Research.LeutholdGroup

With the closely intertwined businesses of semiconductors and semiconductor equipment, it is not surprising that the two industries have historically performed similarly. Yet, in 2024, a colossal disconnect has emerged, with semi-equipment stocks up a paltry 5%, miles behind the booming semiconductors.

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The relative performance of small caps lags the S&P 500 by 75% since 2018, and we wondered why.  Was the Magnificent 7 effect so exaggerated that Info Tech and Communication Services, the sectors at the epicenter of the mega-cap growth boom, created such an overwhelmingly high hurdle that small caps were not able to keep pace with these powerhouse companies?  Alternatively, has small cap weakness been the product of sluggish results across multiple sectors, irrespective of the mega-cap growth issue, such that large caps were superior no matter which direction you looked? We label these two hypotheses as “deep” (relating specifically to the narrow but intense Mag 7 effect in Info Tech and Comm Services) or “wide” (describing failings across most small cap companies and industries) and designed this study to identify the most likely explanation.

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Small caps turned sour in August 2018, and since then, performance has been nothing less than disastrous. Is the enormous shortfall pervasive across small caps in general, or is it due to a top-heavy market with unusually huge returns from a few huge stocks? The answer may be helpful for those contemplating a contrarian position in this unloved corner of the market.

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Traditionally defensive themes such as Staples and Utilities have outperformed over the summer months, reminding investors of the benefit of not going all-in on the AI growth theme. Quality is one of the most robust defensive factors, but even so has managed to outperform during the bull market run that began in October 2022.  While some Quality funds are designed to play defense, others seem more inclined to the offensive side of the field. We recommend that investors decide if they are targeting Quality specifically as a defensive exposure or as a core long-term holding to ensure they select the appropriate fund.

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With renewed worries about the stock market, investors are pursuing safe-haven ideas—and Quality is a long-time favorite. Yet, despite its defensive appeal, the Quality factor has been a prominent bull-market leader, of late. Are the striking returns of Quality due to outsize exposure to the Mag 7—or have other high-quality stocks been equally fruitful in the latest upswing?  

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With Fed rate cuts likely to begin just days from now, the mathematical connection between changing rates and duration means that lower rates are almost certain to result in higher bond prices, an effect that has proven reliable since 2024’s high point in rates last April.  The simple approach of targeting longer durations is complicated by today’s inverted curve, meaning that lower rates will almost surely not manifest themselves through a parallel downward shift in the curve, but will be accompanied by an un-inversion that will return rates to an upward sloping shape.  This twist in the curve’s slope will require investors to target the appropriate spot on the curve to optimize the interest rate effect on bond prices.

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With multiple rate cuts nearly assured through year-end, investors can profit from the iron-clad link between changing rates and bond fund prices. But there are two circumstances that introduce complexity: 1) the yield curve will likely un-invert during this process, and the longest duration funds may therefore not experience the strongest price response; 2) potential changes in credit spreads may either enhance or diminish the duration effect felt by corporate bonds.

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Multi-cap funds face two paradoxes that introduce subtle hurdles into their fund analytics. While it is desirable for a fund to rely on a sound investment process and to follow that process consistently, a successful multi-cap fund might not be able to meet both desires simultaneously. Second, a successful multi-cap fund will always be compared to the highest performing peer group while unsuccessful funds will be compared to a less successful set of peer funds. Attentive fund analysts can overcome the challenges we have identified in this study, assuming they are cognizant of the unique issues facing multi-cap and mid-cap funds. This report is intended to arm analysts with just such insights to ensure that benchmark and peer group comparisons are meaningful and constructive.

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The unbounded nature of large-cap and small-cap styles means that they cover a great deal of territory, while mid-cap stands alone as a bounded style, and such limits significantly influence how a fund is classified. On the other hand, multi-cap is intentionally defined with wide latitude, but shares a style category with mid-caps, despite having little else in common.

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After a strong period of market leadership following the internet bubble low of 2002, small cap stocks have been a great disappointment since 2016. Despite favorable economic conditions and a generally bullish market tone since the pandemic, small caps have failed to deliver on the hope of outperformance in a risk-on environment.  As tactical investors interested in owning smaller asset classes when conditions are favorable, we are taking a fresh look at small caps, attempting to diagnose what has been ailing this market segment and what might be coming next.

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Despite the overwhelming superiority of small cap returns, historically, during the winter months, the last three years have not followed the script. Three consecutive failures of this powerful seasonal influence make us curious if there are other market conditions that may be negatively influencing the smalls.

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The financial performance of Korean companies has retreated to distressingly low levels in recent years. Consider that 67% of KOSPI index members trade at a P/B below 1x, and the median ROE is just 4.9%.  To address the concerns of fading corporate performance, low valuations, and weak stock market returns, the Financial Services Commission joined with the Korean Stock Exchange to announce the “Corporate Value-Up” program in February 2024. The objective is to enhance corporate governance and shareholder accountability and to encourage companies to improve financial performance in the areas of P/B, ROE, ROA and shareholder payouts.

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Two of the most intriguing storylines across global markets in recent years concern Asian economies. The Japanese stock market provided the upside surprise, gaining a remarkable 64% in local currency terms since the end of 2020, making it one of the world’s top performers. On the flipside, South Korea ended April with a cumulative loss over the last three-plus years.

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Our March report titled Lifeboat Drill examined the effectiveness of sectors, styles, and factors in protecting investors during major market declines. We found that Consumer Staples are significant and consistent outperformers during times of distress, serving as “comfort food” for investors trying to minimize their financial and emotional distress in a falling market.  Staples are relatively inexpensive today based on market-relative metrics, and today’s level of cheapness has historically corresponded to positive relative returns going forward.

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Well-respected analysts have been espousing different views on the Staples sector’s overall valuation. Some argue Staples is rather richly priced, while others believe it is a bargain in the making. Disagreement creates opportunities, and we believe a closer look at Staples is in order.

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ETFs that focus on a single sector, style, or theme enable investors to make tactical calls that reflect their outlook and risk tolerance, resetting their risk/return profile to benefit from prevailing economic and market conditions. As fate would have it, the explosion of tactical, thematic funds that began 15 years ago coincided with a drought in market cycles.  Following the Global Financial Crisis, the S&P 500 only experienced one moderate drawdown in the next nine years, meaning that opportunities to judge these new thematic ETFs during market declines were in short supply.  This dearth of real-world corroboration has been remedied in recent years as the market experienced three major declines in the span of 49 months, and this expanded sample size serves as the basis for our current study evaluating defensive ETFs in down markets.

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We are curious if factor ETFs have provided downside protection in recent years’ selloffs or whether their defensive nature, shown by academic studies, is lost in the translation to live-money portfolios.

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Real Estate was the top performing sector in the final quarter of 2023, climbing an impressive 18.8% against the market’s 11.7% gain.  Signs of enthusiasm for the REIT industry have been rare in recent times.  While the S&P 500 gained 96% over the last five years, REITs returned a paltry 31% over that time.  We wondered if last quarter’s success signaled that it was time to take a fresh look at the group.  This report examines the investment merits of REITs as an asset class, using the mental model of evaluating “what you pay vs. what you get.”

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Since the pandemic, investors have been leery of adding REITs to their asset mix due to fears that flexible scheduling and work-from-home will permanently diminish the demand for office space. While that view may prove correct, the magnitude of such a change is much less significant than some might suspect.

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The Magnificent Seven’s remarkable performance defines the stock market in 2023. This basket of the seven largest companies in the S&P 500 index gained an average of 111% vs. an average gain of 9% for the other 493 companies. The combined impact of huge index weights and outsized performance made 2023 one of the most top-heavy markets in history. Whenever assets outperform to this degree over just a few quarters, the valuation alarm bells start clanging. Could the fundamentals possibly justify such a massive advance, or is AI mania responsible for the outperformance?

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